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Why the Liberal plan to tax entrepreneurs who invest will come back to haunt Canada

This is one of the few cases that all Canadians should be up in arms about taxing the rich. It's bad policy, and it's bad for all Canadians

David Kaufman, CEO of Westcourt Capital Corp., says legislators knew exactly what they were doing when they created the current system for the taxation of private businessesGEOFF ROBINS/AFP/Getty Images

By now you are probably familiar with the Liberals’ proposed changes to the tax treatment of privately held corporations, announced in July and currently under intense scrutiny by various stakeholders.

There are two basic pillars to the proposed changes, and both are predicated on the loaded notion of “fairness” among taxpayers. The first pillar addresses “income sprinkling”, or splitting income among spouses and family members of business owners in order to lower total taxes paid by a household. It appears as though pretty much everyone sees major problems with these proposals, and there are countless impassioned and well-informed pieces available online that address the issue in detail.

The second pillar is the proposed dismantling of the 40-year old structure that allows private business owners to effectively shelter their non-reinvested earnings in investment companies (holdcos), investing 74-cent dollars as opposed to the 47-cent dollars that high-earning employees are left with to invest on an after-tax basis.

A great deal has been written about the negative effect this will have on small business owners — the lifeblood of the Canadian economy — from farmers to dentists and doctors to corner store owners. I agree with the many who believe that these entrepreneurs ought to continue to receive tax incentives for starting businesses in order to promote risk taking and drive GDP growth in our country.

Relatively little has been written, however, about the very wealthy entrepreneurs who own not-so-small private companies (the proposals cover all privately owned businesses, not just small businesses), many of which generate millions of dollars of profits each year to their founder/shareholders.

Because we live in a “tax the rich” period of Canadian history (including the highest income tax rates seen in at least two generations), it is not popular to speak out in favour of the top one per cent of the one per cent, since these taxpayers have been demonized by many groups, all in the name of fairness.

Without going into the mechanics of it, the proposed effective 71 per cent tax on passive investments by private corporations (i.e. earnings by companies not reinvested into the business but rather into other investments of any description) strives to achieve “real time integration,” or a state in which entrepreneurs’ profits will be treated as if those monies had been received as salaries.

What seems to be lost on the pitchfork-toting legislators storming the gates of the rich is that the proposed legislation, while seemingly “equal,” is both unfair and draconian.

It is true that taxing a salaried employee making $1 million per year the same in real-time as a business owner who makes $1 million in profit makes them equal. But fair and equal are not the same thing. It is unfair to tax business owners — even the most successful among them — equally to salaried employees, who do not take on the significant personal financial risks associated with entrepreneurship and job creation.

Legislators knew exactly what they were doing when they created the current system for the taxation of private businesses — creating incentives for risk-taking by rewarding success with favourable tax treatment of profits.

To think that taking a machete to the existing incentives without affecting the behaviour of those involved is both crazy and naïve.

First, assuming that Canadian risk-takers would take the same risks in the absence of tax incentives is like assuming that people would give as much money to charity without the tax receipts those donations generate, or that investors would support exploration and development of high risk resource-related projects in the absence of flow-through tax benefits. Removing incentives — especially those so deeply entrenched in our tax code — will dramatically reduce the behaviour promoted by those incentives, often resulting in a decrease in total tax dollars received as the tax rates effectively increase.

The corollary of this is that anyone thinking about buying an existing business in Canada from the countless Baby Boomer entrepreneurs who see the value of their business as their nest egg will now have to think twice, reducing the value of all of those businesses across the board.

Second, the Liberals are missing a critical piece in the “tax passive investments to avoid sheltering and achieve real-time integration” approach: Passive investments are passive to the investor, but are anything but passive to those in whom the investments are made.

Entrepreneurs — especially those with significant retained earnings — tend to invest in other entrepreneurs, since it’s what they know. Tens of billions of dollars are invested each year in business start-ups and growth through a variety of debt and equity instruments in businesses often starving for the growth capital they require.

Taxing these passive investments at 71 per cent will — and of this I am certain — significantly reduce any incentive to take investment risks with retained earnings, dramatically affecting capital formation by active companies and, again, reducing the overall taxes collected on those monies when measured in dollars instead of percentage points.

Third, and perhaps most importantly, the draconian measures proposed will create not only a disincentive to take risk in the first place, but a strong incentive to study and adopt complex structures to take fortunes offshore, resulting in the type of conundrum now faced by American legislators — how to change the tax code to stop taxpayers from paying their taxes outside of the country to avoid outrageous tax rates for business.

If the Robin Hoods among legislators can put aside their “us against them” mentality long enough to consider the two sides of these issues, they will conclude that money and talent, as portable and fluid resources, will inevitably follow the path of least resistance, whether that resistance comes in the form of undue regulation or high taxes. To create a system destined to see these valuable and scarce resources benefit the economies of other countries is as avoidable as it is sad.

The wealthy already pay by far the most in taxes (whether measured in dollars or in percentage points), providing a foundation for government to redistribute wealth in what most loyal Canadians think is, in principle, fair and just.

Should the changes come into force later this year, that will become a watershed moment for Canada — a final crossover from “socially liberal and fiscally conservative” to “socially liberal and fiscally insane.”

This is one of the few cases that all Canadians should be up in arms about taxing the rich. It’s bad policy, and it’s bad for all Canadians.

David Kaufman is CEO of Westcourt Capital Corp., a portfolio manager specializing in traditional and alternative asset classes and investment strategies. He can be contacted at drk@westcourtcapital.com.